Understanding Perps: The Hottest Trading Instrument in Crypto

Perpetual swaps, or 'perps', have become the dominant trading instrument in the crypto market, with an estimated annual volume of $40 trillion to $50 trillion. They surpass spot trading and are the go-to product for professional traders, hedge funds, and retail speculators seeking leveraged exposure to asset prices. Despite their widespread use, the mechanics behind perps are not well understood. To grasp perps, it's essential to understand their origins. In traditional finance, leveraged exposure to an asset typically comes through a futures contract, which expires on a specific date. When the date arrives, the contract settles, and traders must roll their position into the next contract. In crypto's early days, this practice created issues, including futures trading at a premium to the spot price, known as basis, which confused retail traders. Every time a contract expired, positions closed, regardless of whether traders wanted them to. BitMEX, founded in 2014, struggled to resolve this issue by shortening contract durations, but it wasn't until the introduction of perpetual swaps in 2016 that the problem was solved. Perpetual swaps eliminated the expiry date, creating a derivative contract that tracks the price of an asset indefinitely. This created a structural challenge, as there was no settlement date to anchor the contract price to the spot price. BitMEX addressed this through a funding rate mechanism, where a payment is exchanged between traders every eight hours. If the perpetual swap price deviates from the spot price, the funding rate adjusts to encourage traders to bring the price back in line. This mechanism has become the industry standard. The other key feature of perpetual swaps is leverage, which allows traders to control positions larger than their deposited capital. To manage the risks associated with leverage, exchanges use automated liquidation systems to close positions before they can go negative. Perpetual swaps have become the primary venue for price discovery in crypto, with price movements often originating in perp markets before spreading to spot. The structure of perpetual swaps has proven durable, with regulators now exploring their application to traditional assets.